Should you buy Rolls Royce stock?

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Transcript

00:00 When you think of Rolls Royce the first thing that springs to mind is the brand of British

00:04 luxury cars. However Rolls Royce Holdings, the public company that trades on the London Stock

00:09 Exchange is predominantly an aerospace and defence company. It's the world's second largest

00:14 manufacturer of aircraft engines after General Electric. And it operates across four key segments.

00:21 Civil, Aerospace, this includes the development and production of commercial aircraft.

00:26 Defence includes the development of military aircraft and nuclear submarines.

00:30 Power Systems includes on-site power and propulsion systems. And New Markets which

00:36 includes the manufacture of small modular reactors and new electric power solutions.

00:41 Currently Civil, Aerospace contributes 45% to the company's total revenue. Defence is 29%,

00:48 Power Systems is 26%. The New Market segment is currently small and doesn't produce much

00:54 revenue at all. The Defence sector is the most profitable one accounting for 60% of the operating

01:00 profit. Followed by Power Systems. Civil, Aerospace, the largest segment by revenue,

01:05 contributes only 20% of profit. Currently Rolls Royce has a market cap of £13.1 billion. With

01:12 £3.1 billion of cash and investments and £5.6 billion of debt, the enterprise value is £15.6

01:18 billion. From an operating point of view the company looks healthy with £900 million in

01:23 operating profit. The trouble is what lies below that line in the income statement.

01:28 Taking into account £12 billion in contract liabilities, Rolls Royce's net financing cost

01:33 for 2022 was a staggering £2.4 billion. This is not a fair representation though because £1.9

01:39 billion was related to foreign currency losses. Still, even after the adjustment, significant

01:45 debt obligations put the company at risk. And so we've got significant debt and negative net

01:50 income to the tune of £1.2 billion. And low gross margins of 20%. Reducing the level of debt has to

01:57 be the number one priority for management. Rolls Royce operates in a very complex environment and

02:02 its financials are not simple either. This doesn't give a lot of confidence to investors.

02:07 And that's why the share price has declined almost 50% in the last 5 years. Indeed the company has

02:13 been struggling for quite a while. It's top line revenue is slightly lower than it was a decade

02:17 ago. And profits are lower too. And that's why the valuation isn't too expensive at just over 1x

02:23 revenue and 8x EBITDA. All that said, analysts believe Rolls Royce can stage a recovery and get

02:29 to £16 billion in revenue by 2025 and £1.4 billion of operating profit. If it does so,

02:35 Rolls Royce would not only improve its financial position but its valuation multiple would also

02:40 increase. Rolls Royce does occupy a critical space in the UK's aerospace and defence industry and the

02:47 company has support from government. Rolls Royce is also ready to tackle big issues such as nuclear

02:52 power generation and the decarbonisation of air travel. The problem is these projects are immensely

02:58 difficult and expensive. Already with significant debt I think we need to see more evidence of

03:03 improving fundamentals and I give the stock a neutral rating. But these are my personal

03:08 opinions not financial advice and I've got no position in the stock.